How Does An Equity Line of Credit Loan Work?

A home equity line of credit loan works a little differently than the traditional mortgage loan that is amortized over a certain period of years with monthly payments. The equity line of credit works in such a way that the entire loan amount is not usually advanced right at the front of the loan, but is available during a “draw period” which is typically during the 5 to 25 year period.

The repayment is made on the amount of money that is drawn from the loan, plus interest. There may be a minimum monthly payment required, such as an “interest only” type of payment, or the interest plus some amount of principal.

The borrower can make payments of both principal and interest, and the full amount of principal is due and payable at the end of the draw period. This is either as a lump sum, balloon payment, or as an amortized loan payable via a schedule.

The purpose for such a feature is that it is used primarily to fund major purchases such as education for children, medical bills, home improvements or business and investment opportunities.

The interest rates on these types of loans are variable and are usually market sensitive, which differs from conventional, amortized home mortgage arrangements. Usually the interest rates are based upon an index, such as the current prime rate.

In the early 2000s, the equity line of credit loans became very popular, as it provided emergency and investment money, and the interest rates being deductible make for a very attractive situation. This was a very attractive alternative to using credit cards and bank loans, because the interest on those types of credit are not tax deductible under current Federal income tax laws.

The flexibility of the home equity based loans were also very attractive, as there was no fixed schedule of borrowing or repayment, as the terms for repayment are as flexible as a borrower and lender wish them to be.

In most of the lending institutions in the United States, a home equity loan is a recourse loan, meaning that if the borrower defaults on his loan, he will lose his home by foreclosure, because in this instance the borrower is personally liable if he defaults on the loan.

Recently there have been a long period of falling home prices, which makes lenders more vulnerable to not having enough equity in homes to back up the loan as collateral.

Consequently, there have been a number of major banks that have rescinded, reduced, or stopped all home equity borrowing due to this downturn. The courts have held that this is legal due to the increased risk of foreclosure if this economic trend continues over a period of years.

If a borrower has a smaller loan that has not yet reached the net value of the home, some lenders will still allow a loan, but for lesser amounts. These types of loans should be rarely used except for major situations, and the home market has a lot to do with the availability and usage of these types of loans.